Monetary Policy and Sovereign Risk in Emerging Economies (NK-Default)

Cristina Arellano, Assistant Director and Monetary Advisor

Yan Bai

Gabriel Mihalache

January 2020 | Federal Reserve Bank of Minneapolis Staff Report 592
This paper develops a New Keynesian model with sovereign default risk (NK-Default). We focus on the interaction between monetary policy, conducted according to an interest rate rule that targets inflation, and external defaultable debt issued by the government. Monetary policy and default risk interact since both affect domestic consumption, production, and inflation. We find that default risk amplifies monetary frictions and generates a tension for monetary policy, which increases the volatility of inflation and nominal rates. These monetary frictions in turn discipline sovereign borrowing, slowing down debt accumulation and lowering sovereign spreads. Our framework replicates the positive comovements of spreads with nominal domestic rates and inflation, a salient feature of emerging markets data, and can rationalize the experience of Brazil during the 2015 downturn, with high inflation, nominal rates, and spreads.

DOI: https://doi.org/10.21034/sr.592